Venture capital transactions in Mexico
March 2017 | SPECIAL REPORT: EMERGING MARKETS – OPPORTUNITIES AND RISK MANAGEMENT
Financier Worldwide Magazine
Mexico is consistently ranked as one of the most attractive emerging markets in which to invest. The country has a steady economy and throughout the last two decades has slowly transitioned into a middle class country; today, almost half of Mexico’s population (119 million based on the 2015 census conducted by the Mexican Institute of Geography and Statistics) describe themselves as belonging to the middle class.
This stability and Mexico’s open economy has exposed a new generation of Mexicans to new local and international education, training and work opportunities. As a consequence, Mexico has a large number of young, prepared and self-confident entrepreneurs willing to take the risk of starting a new business instead of following more traditional career paths in large companies or at the government.
Historically, startups in Mexico have struggled to obtain funding, whether through capital or debt. For a long time, the only real way to do so was through friends and family. In addition, partnering with a venture capital (VC) fund worried entrepreneurs about losing control of their business and there was a general perception that it would be risky and complicated.
By most accounts, currently VC in Mexico represents only 0.02 percent of the GDP. It is fair to say that the VC market in Mexico is underserved. However, it is also evident that with a little help there are great opportunities for this industry to flourish in a market like Mexico.
The Mexican government has implemented policies to allow VC investment to expand
In recent years, the Mexican government acknowledged the importance of fostering a VC industry and has taken important steps towards that end. There are a couple of substantial aspects of these government efforts that have created some of the basic conditions required for an expansion of VC in the country that are worth mentioning, though they are not the only ones.
First, in 2006 the country’s corporate legal framework was modernised to allow Mexican companies to effectively contemplate essential features of VC investment. Under this legal framework, Mexican corporations may better regulate: (i) options and other types of buy or sell agreements and rights of first refusal, tag-along rights and drag-along rights; (ii) the exercise of pre-emptive rights; (iii) the right of shareholders to withdraw from the company or give them the right to redeem shares establishing either a specific price or the basis to determine a price; (iv) restrictions on the transfer of shares or on the transfer of certain rights over shares; (v) the issuance of special classes or series of shares, for example, non-voting or limited voting rights, non-economic rights other than voting rights, or shares that grant veto rights or with special voting rights; and (vi) deadlock solution mechanisms. In summary, the corporate legal system which has been in force since 2006 (revised and amended ever since) allows the implementation of all the common features traditionally seen in VC transactions in a simpler and more reliable manner.
Second, the government created institutions specifically intended to favour entrepreneurship through education and incentives, and the creation of private equity (PE) and VC funds, particularly the National Institute of Entrepreneurship (INADEM). In 2006, a fund of funds was created with capital from the Mexican development banks and other sources. The fund of funds manages commitments of $700m, and its stated goal is to encourage and develop the PE and VC markets by providing long-term financial resources to Mexican companies, in order to boost their competitiveness and increase their business opportunities.
There are areas in which work still needs to be done, for example, to facilitate the access of companies to public markets when they are ready, and to warrant faster and more reliable access to the court system. There are considerable efforts underway to deal with these aspects.
The overhaul of the legal system and the institutional efforts to create a solid VC industry appears to be creating results.
Based on information provided by Amexcap, the Mexican Association of PE and VC Funds, the total amount of VC commitments in the country during 2016 was $1.5bn, up from $515m in 2010, a compound annual growth rate of 20.4 percent.
The number of VC funds participating in the Mexican market, according to Amexcap, expanded in that same period from five to 57. Ninety-two transactions were closed in 2016 alone.
Mexican entrepreneurs are increasingly assigning value to the experience, knowledge, discipline and better corporate governance that come with VC investment, and are less wary of VC funding.
Investments are being made by funds with Mexican and foreign capital across a broad spectrum of industries, from consumer and financial services to technology, healthcare, e-commerce and consumer goods.
There are good examples of VC funds investing in startups providing new creative financial solutions, such as bitcoin exchanges and other technologies that facilitate payment for goods and services, companies involved in agro businesses, companies that sell low cost good quality products to consumers in the base of the pyramid, and companies developing new technological solutions.
On the fund creation side, the market is also expanding. In 2015, Mexico surpassed Brazil for the first time in terms of the number of fund closings and the total VC raised.
In summary, slowly but surely a strong industry is developing. VC funds are investing more, entrepreneurs are more aware of the possibilities of funding through VC, and there are specialists in the areas relevant for these types of investments (financial experts, accountants, lawyers) who are ready to assist funds and companies. There are also associations of VC funds and other participants that provide a cohesive network that allows interaction and sharing of experiences.
But the VC industry in Mexico is underserved, it seems, by available opportunities.
Implementing VC investment in Mexico
From a legal standpoint, implementing VC transactions in Mexico has some particularities that need to be taken into account. But, as mentioned above, in general terms, the standard features sought by VC investors are available.
Of course, the way to implement a VC transaction may vary depending on the nature of the investment, the value of the proposed business and the complexity of the business arrangement. The documents usually executed in the process of a VC investment in Mexico include, much like other jurisdictions: (i) a letter of intent; (ii) a confidentiality agreement; (iii) a shareholders’ agreement; and (iv) new by-laws of the company.
Letters of intent are used as a start in the early process of negotiations. They usually contain an enunciation of the major agreements of the parties in connection with the investment. In some cases, a term sheet for the preparation of the final documentation is also executed. Commonly, these documents are non-binding and are used only as a reference for the further development of the investment, but are very useful in making clear from the outset the parties’ expectations and a basic framework of the rules that will apply.
Together with the execution of letters of intent, parties execute confidentiality agreements. In some cases these agreements also include some exclusivity provisions.
Once the above documents are signed, the investors conduct a due diligence process on the business. During this process it is not uncommon to detect deficiencies in day to day housekeeping and general corporate compliance; after all, entrepreneurs are focused on developing a business and do not necessarily have the means or the time to invest in these aspects of their business where they do not perceive immediate added value. It is important, therefore, to approach this process with an open mind and work closely with the entrepreneur and the company to address the issues that may come up during due diligence.
At a point when the due diligence process is advanced and there is more visibility regarding the contingencies associated with the company, the parties will start drafting a shareholders’ agreement.
Shareholders’ agreements generally contain a number of provisions regarding management and control, ownership transfers, financial forecasts and milestones and the parties agree to carry the business of the company, following business plans that have been prepared and approved periodically. It is also common that shareholders’ agreements include certain mechanisms for solving possible controversies among the parties. Arbitration is commonly used. Also, other more drastic deadlock solution mechanisms, such as options to buy or sell some of the parties’ shares in the company, may be used.
From a practical standpoint, it is important to approach this process in a sensible and constructive manner. The owners of a business may not have been exposed to a transaction of this type before and may have taken great financial risk in starting a business. Obviously, the company is extremely close to their heart; the owner’s philosophy and values may shape, to a large degree, the company’s own culture, and at the outset management and employees may not always be completely open to the structural changes and accountability that come with a VC investment. The right balance must be found.
There are many other aspects that could be discussed in connection with the VC industry in Mexico and substantial information about it that is publicly available; it is worth taking a deep look at this market and analysing the opportunities it may offer.
Álvaro Sarmiento Lapiedra is a partner at Kuri Breña, Sánchez Ugarte y Aznar, S.C. He can be contacted on +52 (55) 5292 5930 or by email: firstname.lastname@example.org.
© Financier Worldwide
Álvaro Sarmiento Lapiedra
Kuri Breña, Sánchez Ugarte y Aznar, S.C.